Corporate finance - Appunti completi (ENG)

Corporate finance – lecture notes

The basic point of the capital structure module is the Modigliani-Miller (MM) model. The main result of this

model is that the value of an unlevered firm is equal to the value of the levered one:

: =

! "

This is true only without taxes because including corporate taxes we have:

= + ()

" ! #

So it’s equal to the value of the unlevered plus the tax shield. The main assumptions of MM are:

• No transaction costs, imperfections and taxes;

• No insolvency costs: bankruptcy is costless. Companies can go bankrupt but you don’t have any

cost associated with this procedure;

• No asymmetric information;

• No agency conflicts: no conflicts between managers, shareholders, etc.

MM suggested to increase debt for all firms (no industry distinction) as much as possible. The value of the

firm is increasing with the debt: ↑↑↑≅ 100%

Nowadays no company follows this model. A typical debt to assets ratio for an industrial is about around

$ Today we start from a world without taxes and we introduce bankruptcy costs.

= 25 − 30%.

% Default and bankruptcy in a perfect market

We define financial distress when a firm has difficulty meeting its debt obligations (so we need financial

debt to be financially distressed not payables, payrolls, etc.) while default is the situation where a firm fails

to make the required interest or principal payments on its debt or violates a debt covenant. After the firm

defaults, debt holders are given certain rights to the assets of the firm and may even take legal ownership

of the firm’s assets through bankruptcy. Comparison with equity

An important consequence of leverage is the risk of bankruptcy (and MM accounts for it but it excludes the

costs). Equity financing does not carry this risk. While equity holders hope to receive dividends, the firm is

not legally obligated to pay them. No bankruptcy risk if the firm is all equity.

Armin Industries: leverage and the risk of default

Armin is considering a new project. While the new product represents a significant advance over Armin’s

competitors’ products, the product’s success is uncertain:

• If it is a hit, Armin will be worth $150 million at the end of the year;

• If it fails, Armin will be worth only $80 million.

Armin may employ one of two alternative capital structures:

1. It can use all-equity financing;

2. It can use debt that matures at the end of the year with a total of $100 million due: this debt is

risky because in the bad state the firm value is 80 and the debt value is 100.

Scenario 1: new product succeeds

If the new product is successful, Armin is worth $150 million:

• Without leverage, equity holders own the full amount;

• With leverage, Armin must make the $100 million debt payment: and Armin’s equity holders will

own the remaining $50 million.

Even if Armin does not have $100 million in cash available at the end of the year, it will not be forced to

default on its debt (because the value of the firm is greater than the value of the debt, If it does

> ).

not have the cash immediately available, it can raise the cash by obtaining a new loan or by issuing new

shares. If a firm has access to capital markets and can issue new securities at a fair price, then it need not

default as long as the market value of its assets exceeds its liabilities. Many firms experience years of

negative cash flows yet remain solvent.

Scenario 2: new product fails

If the new product fails, Armin is worth only $80 million:

• Without leverage, equity holders will lose $20 million;

• With leverage, Armin will experience financial distress and the firm will default.

In bankruptcy, debt holders will receive legal ownership of the firm’s assets, leaving Armin’s shareholders

with nothing. Because the assets the debt holders receive have a value of $80 million, they will suffer a loss

of $20 million (while equity holders receive 0).

Comparing the two scenarios

Both debt and equity holders are worse off if the product fails rather than succeeds:

• Without leverage, if the product fails equity holders lose $70 million: million;

$150 − $80 = $70

• With leverage, equity holders lose $50 million, and debt holders lose $20 million, but the total

loss is the same, $70 million. If the product fails, investors are

equally unhappy whether the firm

is levered and declares bankruptcy

or whether it is unlevered and the

share price declines.

The decline in value is not caused by bankruptcy: the decline is the same whether or not the firm has

leverage. If the new product fails, Armin will experience economic distress, which is a significant decline in

the value of a firm’s assets, whether or not it experiences financial distress due to leverage.

Bankruptcy and capital structure

With perfect capital markets, Modigliani-Miller (MM) proposition I applies: the total value to all investors

does not depend on the firm’s capital structure. There is no disadvantage to debt financing, and a firm will

have the same total value and will be able to raise the same amount initially from investors with either

choice of capital structure. The costs of bankruptcy and financial distress

With perfect capital markets, the risk of bankruptcy is not a disadvantage of debt, rather bankruptcy shifts

the ownership of the firm from equity holders to debt holders without changing the total value available to

all investors. In reality, bankruptcy is rarely simple and straightforward. It is often a long and complicated

process that imposes both direct and indirect costs on the firm and its investors.

The bankruptcy code

Bankruptcy does not mean liquidation. The US bankruptcy code was created so that creditors are treated

fairly. In the US we have procedures like Chapter 11 (the firm continues to operate reorganizing itself, it’s

debtor friendly) or Chapter 7 (bankruptcy is the liquidation of the firm, a trustee oversees the procedure

and use the proceeds to repay the debt and the firm ceases to exist and usually equity holders don’t

receive anything, = 0). Direct costs of bankruptcy

The bankruptcy process is complex, time-consuming, and costly. Costly outside experts are often hired by

the firm to assist with the bankruptcy process. Creditors also incur costs during the bankruptcy process:

• They may wait several years to receive payment;

• They may hire their own experts for legal and professional advice.

The direct costs of bankruptcy reduce the value of the assets that the firm’s investors will ultimately

receive. The average direct costs of bankruptcy are approximately 3% to 4% of the pre-bankruptcy market

value of total assets. In the real world, there are several costs directly related to bankruptcy: legal

expenses, court costs, advisory fees, the opportunity cost of the time the CEO and CFO spend talking with

creditors. Given the direct costs of bankruptcy, firms may avoid filing for bankruptcy by first negotiating

directly with creditors:

1. Workout: a method for avoiding bankruptcy in which a firm in financial distress negotiates directly

with its creditors to reorganize. The direct costs of bankruptcy should not substantially exceed the

cost of a workout;

2. Prepackaged bankruptcy (prepack): a method for avoiding many of the legal and other direct costs

of bankruptcy in which a firm first develops a reorganization plan with the agreement of its main

creditors and then files Chapter 11 to implement the plan. With a prepackaged bankruptcy, the

firm emerges from bankruptcy quickly and with minimal direct costs.

Indirect costs of financial distress

While the indirect costs are difficult to measure accurately, they are often much larger than the direct costs

of bankruptcy. It is estimated that the potential loss due to financial distress is 10% to 20% of firm value:

• Agency costs: conflicts between shareholders and debt holders (examples: fire sale of assets,

delayed liquidation or costs to creditors);

• Weakened ability to operate: examples: decrease in sales, loss of customers, loss of suppliers, loss

of employees or loss of receivables. The loss of customers is likely to be small for producers of raw

materials.

When estimating indirect costs, two important points must be considered:

1. Losses to total firm value (and not solely losses to equity holders or debt holders, or transfers

between them) must be identified;

2. The incremental losses that are associated with financial distress, above and beyond any losses

that would occur due to the firm’s economic distress, must be identified.

Financial distress costs and firm value

With all-equity financing, Armin’s assets will be worth $150 million if its new product succeeds and $80

million if the new product fails. With debt of $100 million, Armin will be forced into bankruptcy if the new

product fails. In this case, some of the value of Armin’s assets will be lost to bankruptcy and financial

distress costs. As a result, debt holders will receive less than $80 million. Assume debt holders receive only

$60 million after accounting for the costs of financial distress. The total value to all investors is now

less with leverage than it is without

leverage when the new product fails.

The difference of $20 million is due to

financial distress costs.

These costs will lower the total value of the firm with leverage, and MM’s Proposition I will no longer hold.

Who pays for financial distress costs?

For Armin, if the new product fails, equity holders lose their investment in the firm and will not care about

bankruptcy costs. However, debt holders recognize that if the new product fails and the firm defaults, they

will not be able to get the full value of the assets. As a result, they will pay less for the debt initially (the

present value of the bankruptcy costs less). If the debt holders initially pay less for the debt, there is less

money available for the firm to pay dividends, repurchase shares, and make investments. This difference

comes out of the equity holders’ pockets. When securities are fairly priced, the original shareholders of a

firm pay the present value of the costs associated with bankruptcy and financial distress.

Optimal capital structure: the trade-off theory (built on MM)

The goal is always to find the optimal debt level that maximizes the firm value The firm picks its capital

.

structure by trading off the benefits of the tax shield from debt against the costs of financial distress and

agency costs. We can rewrite the MM as:

= + () − ()

" !

Where is the present value of the tax savings from debt and are the financial distress costs.

()

Three key factors determine the present value of financial distress costs:

1. The probability of financial distress: which increases with the amount of a firm’s liabilities (relative

to its assets) and with the volatility of a firm’s cash flows and asset values;

2. The magnitude of the costs after a firm is in distress: financial distress costs will vary by industry:

a. Technology firms will likely incur high costs due to the potential for loss of customers and

key personnel, as well as a lack of tangible assets that can be easily liquidated;

b. Real estate firms are likely to have low costs of financial distress since the majority of their

assets can be sold relatively easily;

3. The appropriate discount rate for the distress costs: which depends on the firm’s market risk. Note

that because distress costs are high when the firm does poorly, the beta of distress costs has the

opposite sign to that of the firm. The higher the firm’s beta, the more negative the beta of its

distress costs will be. The present value of distress costs will be higher for high beta firms.

Optimal leverage

For low levels of debt, the risk of default remains low and the main effect of an increase in leverage is an

increase in the interest tax shield. As the level of debt increases, the probability of default increases. As the

level of debt increases, the costs of financial distress increase, reducing the value of the levered firm.

The graph shows the firm value as function of

the debt. The straight line is the typical MM:

The other lines show three

= + ().

" ! #

different cases of financial distress costs: no

distress costs, low costs and high costs. The

trade-off theory states that firms should

increase their leverage until it reaches the level

for which the firm value is maximized. At this

point, the tax savings that result from increasing

leverage are perfectly offset by the increased

probability of incurring the costs of financial

distress.

The trade-off theory can help explain:

• Why firms choose debt levels that are too low to fully exploit the interest tax shield (due to the

presence of financial distress costs);

• Differences in the use of leverage across industries (due to differences in the magnitude of

financial distress costs and the volatility of cash flows).

Exploiting debt holders: the agency costs of leverage

Agency costs are costs that arise when there are conflicts of interest between the firm‘s stakeholders

(shareholders/agents and debt holders/principal, not managers because they work for shareholders). In

MM we maximize the value of the firm ( and so also the equity) because there are no agency conflicts. In

our world If you maximize without caring of you may have situation where the value

max ≠ max . ,

of the debt goes down (remember that so if goes up but goes down it’s clear that goes

= +

down as well). The optimal investment policy is the policy that maximize but we can have situations

& ∗ ∗

where the aim is to maximize the value of the equity and this leads to where is the firm value

<

achieved with the optimal investment policy. This difference in value is the agency cost. Management

∆

will generally make decisions that increase the value of the firm’s equity. However, when a firm has

leverage, managers may make decisions that benefit shareholders but harm the firm’s creditors and lower

the total value of the firm. The examples are similar to exam questions.

First example: Baxter Inc.

Consider Baxter, Inc., which is facing financial distress. Baxter has a loan of $1 million due at the end of the

year. Without a change in its strategy, the market value of its assets will be only $900,000 at that time, and

Baxter will default on its debt ( A fundamental assumption for the entire course (also exam) is that

< ).

there is limited liability for the company so if it cannot ask shareholders to fill the gap ($100,000).

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Baxter is considering a new strategy. The new strategy requires no upfront investment ( but it has

= 0),

only a 50% chance of success ( = 0,5):

• If the new strategy succeeds: it will increase the value of the firm’s asset to $1,3 million;

• If the new strategy fails: the value of the firm’s assets will fall to $300,000.

Should Baxter take the investment?

The expected value of the firm’s assets under the new strategy is $800,000, a decline of $100,000:

[] = 50% ∙ $1.3 + 50% ∙ $300,000 = $800,000

This project has negative NPV. Despite the negative expected payoff, some have suggested that Baxter

should go ahead with the new strategy. Can shareholders benefit from this decision? The point is that we

want to maximize not To compute the value of the equity in order to take the decision we consider:

, .

• The value of the equity in the initial scenario (no change in strategy): is equal to zero with

certainty because the debt holders will get everything;

• If we consider the new risky project: we have two states of the world:

Good state: the shareholders obtain $300,000;

o Bad state: the equity value is zero.

o

The expected value/payoff for equity holders if the firm takes the project is $150,000. Taking decisions on

behalf of shareholders will lead to accept the new project. Let’s now look at the situation of debt holders:

• The value of the debt in the initial scenario (no change in strategy): is equal to $900,000;

• If we consider the new project: we have two states of the world:

Good state: the debt holders obtain $1,000,000;

o Bad state: the value is $300,000.

o

The expected value in this case is $650,000. The firm value of course is the sum of the two so it’s $800,000.

The source of the gain of shareholders (although

the project destroys value) is the debt. Debt

holders start with $900,000 and this is what they

get if the firm doesn’t act.

In case of the new strategy they obtain $650,000 so we have: (−250)

∆ = −100, ∆ = −250 → ∆ = ∆ − ∆ = −100 − = 150

There is a wealth transfer from debt holders to shareholders (this is the source of gain, not the project). The

shareholders like the project because of this while in reality it destroys value. The debt holders $250,000

loss corresponds to the $100,000 expected decline in firm value due to the risky strategy and the equity

holder’s $150,000 gain. Effectively, the equity holders are gambling with the debt holders’ money.

Shareholders do not care about the state of failure if this value is below the face value of the debt.

Excessive risk-taking (or risk shifting/asset substitution) drives the firm to over-investment (in this case)

We have over-investment because we are taking a project we shouldn’t because it has a negative NPV.

When a firm faces financial distress, shareholders can gain at the expense of debt holders by taking a

negative-NPV project, if it is sufficiently risky (excessive risk-taking, incentive) even though a negative-NPV

project destroys value for the firm overall. Equity holders’ payoff is equal to the payoff of a call option:

unlimited upside, limited downside (if you assume limited liability!):

• The value of equity increases if the firm selects risky investment projects;

• Debt (a combination of the firm’s assets along with a s